In this edition let us focus on risks
• Risk 1: Oil prices flaring up
• Risk 2: higher US bond yields sustaining for longer
• Risk 3: currency depreciation and lower exports
• Risk 4: Continued FPI selling
• Risk 5: uncertainty around elections
• How are our portfolios positioned for these risks?
• Valuation and flows
Risk 1: Sustained higher oil prices
In the wake of Israel and Hamas war, there is a threat on Oil. We consider the following factors: –
- There has been no immediate impact on current global oil production, but the risk is that supply could be disrupted if the US were strictly to enforce restrictions on Iranian oil exports or if disruptions spread to the Strait of Hormuz.
- However, Iran has not been implicated by anyone and there seems to be no direct evidence.
- Iranian oil flows have risen from 2.58mbt in Dec to 3mbd on China’s efforts and most incremental production goes to China and should be stable.
- The US and Venezuela have reportedly progressed in talks that would ease US sanctions by allowing at least one additional foreign oil firm to take Venezuelan crude oil for debt repayment—and if successful, would help boost Venezuelan oil production by around 200 kbd within 4-6 months, from 0.8 mbd currently to 1.0 mbd by 1Q24.
Given the above factors, we believe that since the oil markets are balanced, the spike in prices reflect the risk premium that the current uncertainty warrants and over the next 12 months’ oil should trade around USD80/bbl, except for brief spikes.
Indian economy seems to be well positioned to withstand oil prices at around USD80/bbl and also withstand spikes of short duration. The table below shows the trend of current account deficits over the year and our projections for FY24. It shows that at an average cost of USD87/bbl of oil, our current account deficit would be lower than the capital account surplus and we would still accrue forex. The net balance is reached at between USD105-110/bbl price range. In FY25, as India gets included in JPM bond indices, it will receive around USD25bn of incremental FPI flows which should largely prove stable. This would further strengthen the reserves. Forex reserves are the insurance against external volatility.
Given a relatively good outlook on current account deficit and forex, we believe that the growth impetus in the economy would not be dampened till oil crosses USD100/bbl.
How to hedge against the spike in oil prices?
India offers very few real hedges against spike in oil prices. Taxation increases cap the profits of our oil producers. Oil refining and marketing companies see retail pricing in a manner that protects their overall profits over a period of time.
Other energy sources like Coal, see a strong demand, but here again prices are regulated and volumes are the key driver of profit.
Higher prices of crude keep the policy on renewables on the energy side and the resolve to indigenize other large imports gets stronger. We expect renewable and EMS exposure in our portfolios to experience policy tailwinds.
We have a good exposure to manufacturing and higher energy prices should be expected to dampen margins here. However, with products priced on import parity, and our sourcing of cheaper Russian oil (5 to 10% cheaper), it is giving between USD5 to USD10bn benefit which is divided between oil refining companies, government and Indian manufacturing (showing up in margin expansion).
Being exposed to export oriented sectors like IT services has typically proved to be a good hedge but this space suffers headwinds from the next risk factor and our house is less exposed here.
Risk 2: Sharp uptick in US bond yields and NPA pain for US banks
US is the largest economy of the world and after keeping rates close to zero for a long while, it is seeing a spike in bond yields. The 10-year bond yields are now close to 5% and practically all issued US bonds are at a loss for the bond holders. We saw 3 US banks collapsing when bond yields crossed 3.5% and now on a mark to market basis, more banks would be having very small net worth left. However, banks need not recognize losses on held to maturity paper, unless sold and are having income support from better lending rates (deposit rates still continue to be low). Overtime, hence, the impact of treasury losses can be taken care of through higher NIMs.
The other risk in the US is the stalling of real estate market where borrowers would see loan rates spike up over a period of time and new houses are selling for lower than old and owners may have to put in house equity rather than take out house equity. This raises the concern on bad loans spike from a sector considered safe and also other sectors for same/similar reasons.
Overall, banks there are pointing to lower margins (better NIMs but higher recognition of losses) vs earlier and most bank stocks are not doing well.
There is a possibility of more banks collapsing as FED tightens further over a period of time. However, this time around there is a difference vs Lehman collapse. Lehman had a lot of OTC derivative contracts and its collapse suddenly led to counterparty risk and markets froze. This risk is much less today. Collapse of 3 banks in the past happened without creating market ripples.
Higher US bond yields leads to a flight of capital to the US. Indian corporates would find rollovers of debt more difficult in the next year and could result in forex outflows.
Also, higher US yields (along with inflation impetus from higher Oil prices) would constrain the RBI’s ability to lower domestic rates and we should be prepared for higher yields for longer.
Here again our forex levels provide a level of comfort against foreign volatility washing upon Indian shores.
How are we positioned for this risk?
BFSI is a large exposure for Indian IT and hence we believe that slower growth of Indian IT could continue (while order bookings are strong) as clients go slow on execution. As a house, we are underweight IT and exporters and are more focused on domestic themes. The midcap IT companies that we are exposed to have a relatively lower (if any) exposure to BFSI.
Sustained higher bond yields may lower the pressure of NIMs on Indian banks. We are invested into high AUM growth banks. High AUM growth would be the key driver for profit growth in the next period.
Risk 3: sharp currency depreciation
INR is trading at the lowest level vs the USD. However, it has been more stable than the past vs itself and relatively better performer vs peer group currencies. Improving prospects on current account deficit and inclusion in JPM bond index are tailwinds that India has vs other countries and should help keep currency relatively stable as we go forward. However, if the forex reserves have a sharp fall for any reason, we expect RBI to focus on shoring up reserves, which gives it credibility and makes INR more stable than otherwise, rather than defend the currency.
A depreciation in currency actually provides some margin tailwinds to India Inc. In the past, the market used to react negatively to a currency depreciation because the FPIs pulled money out in anticipation to save against forex related losses. However, now since domestic flows are the dominant flows in the market, this risk is much lower. Like most markets who react positively to a currency depreciation, we expect the same to be seen in Indian market as we go forward.
Risk 4: FPI selling in equities
We believe that at current high bond yields, it does not make sense for an international investor to invest into emerging markets. India has seen some FPI flows on account of substitution effect (from other emerging markets) while overall, EMs may have seen outflows. This situation can continue.
FPI selling is seen more in the larger cap spaces which are more owned by them. Sectors which are large and liquid, such as banks and IT may be seeing more of selling.
However, global Investment banks such as CLSA and Morgan Stanley have been advising clients to bump up India exposure and this may help keep selling pressure, if any, low.
How are our portfolios positioned for this risk?
Like we have shared before, story of domestic markets is that of domestic investor coming into the market structurally. Formalization of economy and improving per-capita, is resulting in investible surpluses. SIPs are now a larger part of net inflow into the market and half of the money seems to be going to the mid and small cap funds.
On flows hence, while the mid and small caps have some tailwinds, larger caps have some head winds. Our portfolios are growth oriented portfolios focused on growth themes. The best exponents of the theme are more present in the midcap and small cap space. Hence our portfolios have tailwinds of domestic flows.
Risk 5: Uncertainty of election outcome
If we look at the performance of the market 6 months before the elections, over the past 8 elections, only once was the returns negative. Similarly, over past 8 elections, only twice were the returns negative six months’ post elections.
We believe that post Covid, the ability of policy makers to provide protection to Industry is higher as every country wants more manufacturing internally on supply chain issues. Hence a lot of the present supportive policies should be expected to continue.
How are our portfolios positioned?
The growth themes we are focused on are all themes that benefit the nation over the medium to long term and hence should be expected to continue to see policy support. Focus on high quality of business and management further reduces associated risks.
We believe that this is time for alpha
Two months back we had shared our thoughts on various market spaces which were experiencing growth tailwinds and which are less present in a large cap index. Also, as shared above, we believe, our portfolios are positioned to navigate the risks in the environment.
The earnings growth in the midcap and small cap part of the market continues to be better than what the large cap indices are experiencing. This has a large influence of supportive government policies and should continue to provide better growth till policy environment continues to be supportive. We believe we can sustain for a brief period, a spike in crude prices. High forex reserves enables our policy makers to continue to focus on growth especially since outlook on forex reserves is good on account of lower CAD and inclusion in global bond market indices.
Hence, we believe, it continues to be Time for Alpha.
Valuations are now at the upper end of the sustainable band. Our construct for the market is 18-18.5X one year forward earnings which gives us a target of around 20350 for Nifty on 1100 nifty earnings for FY25. This leads us to expect a slightly lower than earnings growth returns over the next few years. However, the earnings growth over this period should be faster than long period average. Midcaps are trading at a small but sustainable premium over large caps. Given the strong presence of the growth themes in the midcap space, we do expect the space to continue to perform on a relative basis. This should continue till policy stays supportive.
Overall, we believe that we run some of the fastest growth in EPS portfolios in the industry and believe that higher sustained growth of our portfolio companies should provide tailwinds for sustained performance. Presence of all growth themes and exposure across market cap spectrum provide our portfolios with a good chance of participating in the performance of any growth space as well as providing diversification benefits. Our portfolios are well diversified and have lower top 10 stock concentration vs the Index in most cases, further providing risk control. This we believe improves our chances for sustained performance in the next period.
May the Good Times Continue
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